Chapter 12
Capital Budgeting:
Decision Criteria
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Ch 12: Capital Budgeting Decision
Criteria
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Topics
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Overview
Methods
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Payback, discounted payback
NPV
IRR, MIRR
Profitability Index
Evaluating projects with unequal lives
Economic life
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What is capital budgeting?

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Analysis of potential additions to the
capital budget.
Long-term decisions; often involve large
outlays.
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Steps in Capital Budgeting
1. Estimate cash flows.
2. Assess risk of cash flows.
3. Determine required return (r).
4. Evaluate cash flows.
Chapter 12 focuses on step 4: evaluation
of cash flows.
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Capital Budgeting Techniques
The best capital budgeting techniques:
Use cash flows (not unadjusted
accounting numbers)
2.
Consider the time value of money.
We refer to them as DCF (discounted cash
flow) methods.
1.
Examples of DCF methods: NPV, IRR,
MIRR.
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Corporate Practice
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Capital budgeting practices of US
corporations:
99% use IRR or MIRR
85% use NPV
84% use payback
23% adjust WACC by divisions
73% adjust WACC for project risk
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Payback
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Payback: # of years to recover a
project’s cost.
Decision rule: based on firm’s policy.
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Net Present Value: NPV
n
NPV = ∑
t=0
CFt
(1 + r)t
Cost often is CF0 and is negative.
r is cost of capital (discount rate).
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Rationale for the NPV Method
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NPV = PV inflows – Initial investment
NPV measures change in firm value, so
the decision rule is:
Accept if NPV > 0.
Rank mutually exclusive projects on
basis of higher NPV.
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Internal Rate of Return: IRR
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The IRR: the discount rate that causes NPV
to equal zero.
IRR is one measure of the percentage return
on a project.
Accept if IRR > cost of capital (r)
If IRR > WACC, the project’s rate of return is
greater than cost of financing.
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Comparing NPV & IRR
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NPV assumes reinvestment at r (cost of
capital).
IRR assumes reinvestment at IRR.
Reinvestment at cost of capital, r, is
more realistic. This is one reason NPV is
better method than IRR.
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An Alternative Measure of
Returns: MIRR
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Even though NPV is a better technique than
IRR, managers prefer percentage returns. Is
there a better measure of return than IRR?
Yes. MIRR is the % return on a project if cash
flows are reinvested at the cost of capital.
MIRR also avoids the problem of multiple
IRRs.
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Normal vs. Nonnormal Cash
Flows
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Normal Cash Flow Project:
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Cost (negative CF) followed by a series of positive
cash inflows.
One change of signs.
Nonnormal Cash Flow Project:
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Two or more changes of signs.
Most common: Cost (negative CF), then string of
positive CFs, then cost to close project.
Examples: nuclear power plant or strip mine.
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Nonnormal CFs
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Projects with nonnormal CFs:
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Can have one IRR, no IRR or more than
one IRR. Even if IRRs exist, they have no
economic interpretation.
Use MIRR &/or NPV for such projects.
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Ranking Mutually Exclusive
Projects

Consider two mutually exclusive
projects, A & B:
Project
NPV
A
$12,000
B
$98,000
This is an example of a ranking
should be chosen?
IRR
28%
22%
conflict. Which one
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Mutually Exclusive Projects
with Unequal Lives
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Typically, we can rank mutually
exclusive projects on the basis of NPV.
An exception to this is the case of
mutually exclusive projects with
unequal lives that will be repeated.
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Mutually Exclusive Projects
with Unequal Lives
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To evaluate mutually exclusive projects
with unequal lives, we:
Use replacement chain NPV
or
 Use equivalent annual annuity
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Choosing the Optimal Capital
Budget
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Finance theory says to accept all
positive NPV projects.
Two problems can occur when there is
not enough internally generated cash to
fund all positive NPV projects:
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An increasing marginal cost of capital.
Capital rationing
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